Pan-American Surety Association Newsletter
"News@PASA 3/4 of 2005

Typical Surety Defenses Under United States Law

By: William J. Taylor, Esquire
Philadelphia, PA
USA

This article examines various defenses available solely to a surety in the context of a claim upon a performance bond. Generally, under U.S. law a surety's liability is no greater than the liability of its principal. Any defenses to a claim that are available to a principal are also available to its surety. However, there are numerous defenses to a surety's liability which have little to do with the principal's liability, and which might not be asserted by an attorney retained by, and interested solely in, the principal. Some of these defenses, such as the failure to satisfy a condition precedent, can be determined simply by reading the face of the bond. Others require a more detailed knowledge of the law of suretyship. An attorney representing a surety as well as a principal should be aware of these basic surety-related defenses.

Failure To Satisfy Condition Precedent. Often a bond will state on its face a condition precedent that must be satisfied before a claim under it can be asserted. For example, some performance bonds in common use in the U.S. require, before the obligee can seek relief under the bond, that the obligee declare the principal to be in default, in accordance with the contract's default procedures. The bond, or the governing statute in the case of a public works bond, may also contain strict notice requirements that must be followed before a claim on the bond can be asserted. The failure of an obligee to satisfy a condition precedent will preclude an otherwise valid claim against the surety.

An example of the successful assertion of such a defense was seen in the leading U.S. case on this subject, L&A Contracting Co. v. Southern Concrete Services, Inc., 17 F.3d 106 (5th Cir. 1994). Because the general contractor in that case failed to adequately declare a default, a subcontractor's performance bond surety was found not liable under the terms of its bond, even though its principal had obviously failed to perform. The performance bond expressly provided that the surety would become liable to take certain actions to remedy its principal's breach "[w]henever the Principal shall be, and shall be declared by Obligee to be in default under the subcontract, the Obligee having performed Obligee's obligations thereunder." The U.S. court found that the principal did indeed breach its subcontract with the obligee. However, even though the obligee had sent ten letters to the surety informing it of the principal's deficient performance, the surety was found not liable. The court found that the obligee's letters did not establish a declaration of default sufficient to invoke the surety's obligations under the bond.

Material Alteration Of Surety's Risk. In issuing its bond, the surety signs on to known risks, i.e., those risks set forth in the contract between the principal and the obligee. A change in those risks, even if agreed upon, can result in a discharge of a surety's liability if the change is made without the surety's notice and consent.

For example, the principal and the obligee may, for a mutually acceptable price increase, agree to changes in the scope of the work. Usually the terms of the contract provide for both changes in the work and notice to and consent by the surety, and thus these changes do not result in the discharge of a surety's obligations. However, courts have found differently in the case of a material change, which is a change or a series of changes that are so great that the resulting contractual risk goes far beyond what was originally contemplated by the surety. A surety's obligations can be discharged even if the principal and the obligee agree to a material change.

In one case involving a material change, the principal/general contractor and the owner/obligee altered, by way of contract addendum, the payment schedule for the contractor's work. However, the addendum was issued several months after the surety had issued its completion bond. The U.S. court held that by virtue of the addendum "the contract [payment] terms had undergone a substantial change, certainly of such a nature as to enable a surety to claim with reason that it should have had an opportunity to review its risk before deciding whether to adhere to its commitment to guarantee performance."

Changes In Payment Procedures. The risk to the surety may also increase if the obligee makes advanced or early payments to the principal. Most construction contracts in the U.S. provide for progress payments to be made in accordance with the amounts or percentage of labor and materials expended by the contractor. Early or advance payments made by the owner/obligee at one stage of the contract will usually mean that there will not be sufficient funds available to pay for the labor and materials expended by the contractor/principal at a later stage of the work. Instead, this work may have to be paid for by other funds the contractor may have--or by the surety's funds. Similarly, retainage is usually withheld during the course of a project to ensure that the contractor completes the work. If retainage is released early, the contractor may have no incentive, or possibly no funds available, to pay for the completion of the work, leaving the surety liable.

An overpayment does not always result in the complete discharge of the surety. It is more likely that a court will reduce the surety's liability by the amount that the overpayment has prejudiced the surety's position-which is often the amount of the overpayment itself. In one prominent U.S. case involving the construction of new sewer lines the court found that the obligee/city made improper payments to the principal/contractor when it paid for materials that were delivered to the worksite but not yet installed, and also when it paid for the installation of other pipe that was never actually installed. The court noted that a premature payment does not automatically mean that a surety has been prejudiced, especially when an advance payment is made reasonably and in good faith. Thus, the court reduced the surety's liability for the amount paid for the uninstalled pipework, but not for the amount paid for the materials delivered. Even though the contract specified that materials would not be paid for until they were installed, the court found that the obligee's advance payment actually protected the surety from additional financial exposure, and a discharge of liability for this advance payment was denied.

Statute Of Limitations. In some U.S. jurisdictions, the statute of limitations for bringing a claim under a surety bond may differ from the statute governing claims that the obligee may bring directly against the principal. This may be especially true for statutory bonds, in that the statute often contains a specific time period for asserting a claim. Even for private bonds, the limitations period may be shorter for surety bond claims. These limitation periods, which the courts are usually willing to enforce, may be found in the applicable state statutes or in the terms of the bonds themselves. For example, in one U.S. case the court enforced a two-year statute of limitations that was expressly set forth in the bond rather than the state's ten-year limitations period on actions for breach of contract.

Fraud Or Misrepresentation. Usually fraud by the principal alone is not sufficient to discharge or otherwise limit the obligations of a surety. However, if the obligee participated or assisted in fraud, such as concealing the full scope of the work required under the contract or the full extent of risk, the surety may have a complete defense to liability.

In one case where this principle was noted, the court observed that "[a] creditor who, during negotiations, actively and fraudulently conceals pertinent facts cannot then turn to the surety for reimbursement" and that "the surety has a defense to liability if, before the obligation is undertaken, the creditor knew of facts unknown to the surety and which he had reason to believe were not known to the surety, the facts materially increased the obligor's risk and the creditor had adequate time to disclose them but failed in his responsibility."

When a surety in the United States is presented with a claim it should always determine if any of these surety specific defenses are available. The surety should never simply rely solely on any defenses that are available to its principal. Often, this means that the surety should retain its own attorney, and not simply tender its defense of a claim to its principal and its principal's attorney.